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Contents 1	Overview 2	Market Consequences 3	Examples 4	Responses 5	References Overview Circular trading is a fraudulent practice that can take place in stock markets, causing price manipulation.[1] This practice works where sell orders are entered at the same time identical buy orders are made with the same number of shares and the same price. As a result, there is no beneficial change in ownership of shares but there is the appearance of an increased trade volume. This can be achieved by several parties colluding to achieve the fraudulent outcome. This is not to be confused with wash trading, which is where the same outcome is achieved but occurs through the actions of one investor, rather than a group.

Circular trading is based on the premise that trading volume has a direct impact on share price. Trading volume increases are widely regarded as a signal that something important is happening within a company,[2] for example a new product or a change in management may be being announced.[3] As a result, investors buy shares in order to take advantage of the expected increase in share value. This increases the value of the shares, at which point they become overvalued. Circular trading is fraudulent because the signal that investors receive to buy shares has no basis in reality and is made with the sole purpose of creating interest where none is warranted.[1]

This fraudulent practice is therefore widely considered unethical and is banned in many countries. This issue is most prevalent in India,[3] where companies such as Videocon Industries Ltd had their shares devalued fraudulently by the brokers Mansukh Securities and Finance Ltd. and Intec Shares and Stock Brokers Ltd.[3]

Circular trading has become a particularly important issue since the advent of high-frequency trading in the 1990's. This trading platform allows large investors and investor groups to perform an extremely high number of transactions in a short period of time through utilising powerful computers to automate transactions.[4] This can be used to buy and sell shares in single stocks at rates which are immensely more rapid than that which humans can achieve manually. As a result, creating the appearance of high trading volumes has become much easier, particularly in large companies where the number of transactions required to simulate a realistic level of activity far exceeds what humans are capable of creating manually.

Market Consequences The most common form of circular trading is where groups of investors fraudulently inflate the share price of a company, at which point they sell the shares they own for a profit.[1] While this is illegal, the market consequences are usually minimal. In a smaller number of cases, circular trading is used in a way that has a direct impact on the success and failure of companies.

In some cases, shareholders set thresholds for the price of shares at which they will stay invested within a company or leave it. Another example of this is where shareholders set a price threshold at which they will decide to purchase more shares. This is important because it is common for shareholders to follow the decisions of those around them, meaning that if a small number of influential shareholders leave a company, it can pose a risk to the overall health of the company. Once these thresholds have become reasonably well defined, circular traders then manipulate the stock prices to always stay on the side of the price threshold which is in their best interests, regardless of the real value of the shares.[3]

Circular trading can also have severe market consequences in relation to Initial Public Offerings (IPOs). Since the level of ‘buzz’ and ‘hype’ around a companies’ IPO is a significant factor in the success of the IPO, efforts to fraudulently manipulate that level of excitement can create significantly overvalued companies.[3] The result of this is that companies which initially appear to be full of potential are over-hyped and inevitably find themselves with demand and expectations which they cannot fulfil. This not only results in the initial investors losing their investment when the company fails, but also has the ability to contribute to a lack of confidence in the stock market in general.

Beyond the broad-reaching market consequences, the consequences for private individuals who invest in the stock markets are also significant. In this scenario, individuals will spend more money on shares than the shares are worth. Even if the long-term result is that they make a profit on the shares, this does not change the reality of their overpayment in the purchasing of the shares. As a result, whenever instances of circular trading are discovered, it results in further erosion of public trust in the stock markets as a whole, as consumer confidence changes are very rarely confined to the specific stock market issue that is raised at any given point in time.[5]

Examples Circular trading has been most prevalent in India, with the majority of high profile cases originating in the Indian stock market. The first case to receive public attention was that of Ketan Parekh, a stockbroker who was found guilty of a major stock market scam dating back to 1999. This was largely based on circular trading, although insider trading was also a significant component.[6] In this case, there were seven companies acting in union to illegally manipulate the market. The companies illegally bought shares in companies leading up to the date of their IPO's, effectively driving the share value up, before offloading the shares directly after the IPO. This was a clear example of using circular trading to artificially inflate a company's value so as to mislead investors about the value and popularity of particular IPOs. As a result, Parekh was barred from acting within the Indian stock exchange until the year 2017. The case of Parekh has gained notoriety because he was found violating the ban on his involvement in the Indian Stock Exchange. A 2012 report found that Parekh was not only still active in the Indian Stock Exchange, but he was also continually engaging in serious violations of the law, including insider trading and circular trading.[6] In April 2012, Parekh colluded with his Singapore-based associate Akshay Natra, executing several synchronised trades in the shares of Nifty Bank, leading to an illegitimate profit of approximately 10,000,000 Indian Rupees.[6]

Another case occurred in 2001 when the Securities and Exchange Board of India (SEBI) accused Angel Broking of creating artificial trade volume in the shares of Sun Infoways Ltd for a period of approximately one month between February and March of that year.[3] Angel Broking colluded with three lesser-known brokerages to achieve this. The market consequences of this case were quite severe as the targeted shares were being traded between the prices of 296 and 342 Indian Rupees during the period the circular trading was active, before dropping as low as 61 Indian Rupees in the following month when the publicly visible trading volume became legitimate.

Another case that received public attention was the barring of Shankar Sharma in 2009 from the Indian Stock Exchange for a period of one year. Sharma was involved in circular trading through his position as Joint Managing Director of First Global Stock Broking Limited. [3]

Aside from that of Ketan Parekh, the most significant case of circular trading was when SEBI barred 16 people from trading on the stock market for circular trading in 2010.[7] This involved being barred from buying, selling and dealing in securities on the market, as well as having their bank accounts frozen. This was in response to proof that these individuals had created artificially high volume in the market through synchronised trading among themselves. This case became widely considered important because it involved numerous large companies. The targeted companies were Marvens Biotech, Rasi Electrodes, Sat Industries, KSL & Industries, Asian Star Co, Allcargo Global Logistics, Panoramic Universal, and Ushdev International.[7] This case created a large scandal in India because the use of circular trading caused investors to lose faith in the accuracy of share prices on the Indian stock market, which affects many more companies than just those specifically targeted. Following this, in 2012, SEBI imposed a penalty of 200,000 Indian Rupees on the brokers involved. [3]

Responses Methods for preventing circular trading have been in development since the outbreak of high profile cases in India, starting in 2010. In India, SEBI has begun using several methods aimed at preventing this fraudulent practice. In general, this is done through increasing regulation on the stock market in a way that restricts trading high volumes of stocks in short amounts of time.[3] One such method includes a price band which is a range of prices which is set for a day, and specific stocks can only be sold within the price range on that day. As of 2018, SEBI has imposed a 10% price band for all stocks on the market. However, the issue with these restrictions is that they can restrict genuine price movements that may occur in companies when important events occur, such as a management change. Especially in the case of speculative companies, an example being mining companies which experience a sharp spike in share price following a successful resource find, the price bands can severely dampen the genuine growth which is relied upon in these instances. As a result, SEBI has begun varying the price bands based on industries and specific companies in order to avoid these issues.[3]

There are also inter-week price bands which restrict price movements over a week, with a larger variation of 25% being allowed.[3] This is aimed to prevent large swings in price having a direct impact over more than one trading period. Margins have also been introduced. This initiative by SEBI requires that for each transaction that a broker orders, they must also deposit a small amount to the stock exchange. This is essentially a transaction charge that disincentivises brokers to place orders unnecessarily. This is relevant to circular trading as without a transaction charge, groups could trade shares amongst themselves many times at no cost with no change in real ownership while still creating the appearance of trade volume. The margin means that although circular trading is still possible, it now has a charge which cannot be avoided.

In addition to these institutional measures which seek to make circular trading more difficult, there is also a field of academic research that is seeking ways to detect circular trading in a faster and more accurate manner than is currently possible. This is a field which first saw success in 2018 when Ramin Salahshoor published a paper demonstrating success in detecting circular trading using a network-based approach, using data from the Iran Mercantile Exchange.[8] This was achieved by constructing networks of daily trades by several separate traders, and then analysing trade cycles of various lengths from these networks. From this, Salahshoor was able to group traders from each day into groups of traders who were engaged in suspicious cycles which were indicators of circular trading, and traders who were acting legitimately. This was possible because of the nature of herding in stock markets. Salahshoor noted that when the circular traders inflated the share price, they were effectively herding a larger number of legitimate investors into also buying these shares. By analysing which investors were commonly the instigators of this herd mentality, Salahshoor was able to identify which traders were acting illegitimately.[8] Salahshoor also factored in price fluctuations over time so that randomly generated suspicious cycles were eliminated from his analysis. Prior to this breakthrough, circular trading was only detectable through initial guesswork and intuition based on discrepancies between the level of trade volume recorded and what should be expected, as well as rapid changes in trade volume that did not have any obvious cause in the real-world situation. Salahshoor's method has had success in identifying circular traders in Iran already. This is an indication that further research in to this area will lead to methods that will allow for the increasingly swift and accurate identification of circular traders in various types of markets.[8] This is particularly important considering that circular traders are currently only ever brought to justice after significant market damage has already occurred.

References Investopedia. (2018). Circular Trading. Available: https://www.investopedia.com/terms/c/circulartrading.asp. Last accessed 10th Sep 2018. 2.	Investopedia. (2017). How Can Trading Volume Exceed Shares Outstanding?. Available: https://www.investopedia.com/ask/answers/05/sharestradedoutstanding.asp. Last accessed 15th October 2018. Sharma, R. (2014). Circular Trading in Stock Market. Available: http://www.blog.sanasecurities.com/circular-trading-stock-market/. Last accessed 10th Sep 2018. Investopedia. (2018). What is high-frequency trading? Available: https://www.investopedia.com/ask/answers/09/high-frequency-trading.asp. Last accessed 15th October 2018. Investopedia. (2018). Understanding the Consumer Confidence Index. Available: https://www.investopedia.com/insights/understanding-consumer-confidence-index/. Last accessed 15th October 2018. Pannu, S. (2012). Stockbroker Ketan Parekh in major stock market scam, reveals IB report. Available: https://www.indiatoday.in/business/market/story/stockbroker-ketan-parekh-major-stock-market-scam-ib-report-108321-2012-07-07. Last accessed 10th Sep 2018. Economic Times. (2010). SEBI bars 16 people from market for circular trading. Available: https://economictimes.indiatimes.com/sebi-bars-16-people-from-market-for-circular-trading/articleshow/5603771.cms. Last accessed 10th Sep 2018. Salahshoor, R. (2018). A Novel Approach for Circular Trade Detection in Mercantile Exchange. Available: https://geistscience.com/papers/view/JFER1803103. Last accessed 29th Oct 2018. Categories: Stock traders